Anomalies in option pricing: the Black-Scholes model revisited

Contents:

In 1973, Myron Scholes and the late Fischer Black published their seminal paper on option pricing. The Black-Scholes model revolutionized financial economics in several ways: It contributed to our understanding of a wide range of contracts with option-like features, and it allowed us to revise our understanding of traditional financial instruments. This article addresses the question of how well the Black-Scholes model of option pricing works. The goal is to acquaint a general audience with the key characteristics of a model that is still widely used, and to indicate the opportunities for improvement that might emerge from current research. The article reviews the key features of the Black-Scholes model, identifying some of its most prominent assumptions. The author then employs recent data on almost one-half million options transactions to evaluate the Black-Scholes model. He discusses some of the reasons why the Black-Scholes model falls short, and goes on to assess recent research designed to improve our ability to explain option prices.

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